Investors were disappointed with the weak earnings posted by Linkage Software Co., LTD (SHSE:688588 ). While the headline numbers were soft, we believe that investors might be missing some encouraging factors.

A Closer Look At Linkage Software's Earnings

Many investors haven't heard of the accrual ratio from cashflow, but it is actually a useful measure of how well a company's profit is backed up by free cash flow (FCF) during a given period. The accrual ratio subtracts the FCF from the profit for a given period, and divides the result by the average operating assets of the company over that time. The ratio shows us how much a company's profit exceeds its FCF.

Therefore, it's actually considered a good thing when a company has a negative accrual ratio, but a bad thing if its accrual ratio is positive. While it's not a problem to have a positive accrual ratio, indicating a certain level of non-cash profits, a high accrual ratio is arguably a bad thing, because it indicates paper profits are not matched by cash flow. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

For the year to March 2024, Linkage Software had an accrual ratio of -0.10. Therefore, its statutory earnings were quite a lot less than its free cashflow. In fact, it had free cash flow of CN¥100m in the last year, which was a lot more than its statutory profit of CN¥36.9m. Linkage Software did see its free cash flow drop year on year, which is less than ideal, like a Simpson's episode without Groundskeeper Willie.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Linkage Software.

Our Take On Linkage Software's Profit Performance

Linkage Software's accrual ratio is solid, and indicates strong free cash flow, as we discussed, above. Based on this observation, we consider it likely that Linkage Software's statutory profit actually understates its earnings potential! Unfortunately, though, its earnings per share actually fell back over the last year. At the end of the day, it's essential to consider more than just the factors above, if you want to understand the company properly. So while earnings quality is important, it's equally important to consider the risks facing Linkage Software at this point in time. To that end, you should learn about the 3 warning signs we've spotted with Linkage Software (including 1 which is a bit unpleasant).

This note has only looked at a single factor that sheds light on the nature of Linkage Software's profit. But there is always more to discover if you are capable of focussing your mind on minutiae. Some people consider a high return on equity to be a good sign of a quality business. So you may wish to see this free collection of companies boasting high return on equity, or this list of stocks that insiders are buying.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.